Many employee benefits simply offer health insurance and a group RRSP or DC pension plan.
But people at the top of the pay scale have often maxed out their registered plans. They need a plan where contributions can be both tax-deductible and tax-deferred, and it exists: it’s called a Retirement Compensation Arrangement (RCA). Many executive-level compensation and benefit strategies cannot provide tax relief when marginal tax rates approach the 50% mark. That’s because DPSPs, RRSPs and pension plans hit their maximum contribution levels once employment earnings reach $144,500 (2016).
Companies often resort to bonuses, equity compensation or other perks to create incentives to address the gap left by registered plans, but these strategies do little to mitigate tax, provide retirement savings or create meaningful longer-term incentives.
Example: A bonus
Let’s see what the impact of a bonus is to both the employer and an Ontario employee.
The company employs 50 staff, three of which are senior management.
In 2016, a senior manager makes $220,000 per year and receives a $50,000 bonus.
Since the company’s payroll exceeds $400,000, each bonus incurs an Employer Health Tax of 1.95%. That’s another $2,925 of tax paid by the company, so each $50,000 bonus actually costs the company $52,925.
As for the senior managers, each would pay $26,765 of tax on the bonus, netting $23,235. That means for every dollar spent by the company, only $0.44 landed in the executive’s pocket after taxation.
What’s the solution?
In 1985, the federal government introduced Retirement Compensation Arrangements (RCAs) to provide for benefits above registered limits. Contribution amounts are entirely tax-deductible from earned income to the contributor (the employer). If an employee also contributes to an RCA, her contributions are also tax-deductible. Income tax on the contributions themselves is deferred to retirement; then, like an RRSP, withdrawals are taxable as income.
The downside? You can only invest half the contributions. The other half is kept by CRA in a no-interest account—but that’s still much better than paying more than half in taxes.
What’s in it for the company? RCA contributions do not attract EHT, saving 1.95% off the bat. Also, the RCA can be integrated into an existing group pension plan to provide continuity of benefits for earnings in excess of $144,500.
Most importantly, RCAs rules allow vesting to take longer than two years, which is the limit for most registered plans. That means it’s now possible to provide a funded retirement benefit plan, with objectives that must be satisfied before employees receive anything. This ensures that the goals of the employee and the company are aligned.
Canada’s annual real GDP growth rate in Q1.
Source: Statistics Canada
Other RCA benefits
An RCA can fund employee severance payments, reducing the cost of severance for both sides by creating a taxable lump-sum amount; this can be useful for employees who do not intend to return to the workforce.
Tax rates are generally more favourable at that time, as taxation at retirement is based on jurisdiction. For example, non-residents employed on our side of the border may postpone tax in Canada and withdraw at rates as low as 15% in some U.S. states on structured payments from an RCA for more than 10 years. This is one of the reasons that RCAs can be favourable to foreign workers, including many professional athletes—last year, the NHL rolled out RCAs as part of the players’ pension plan.
The following is a simple illustration of how tax-efficient an RCA can be.
A 55-year-old Ontario executive is retiring at year-end, and is entitled to a taxable severance of $500,000 on December 31, 2016.
His marginal tax rate is 53.53% in 2016.
Funds are invested in a corporate-class mutual fund and return 5% (1% are qualified dividends; 4% are deferred capital gains).
Equal amounts of the severance proceeds are withdrawn over five years.
The executive has no other income over this time.
All withdrawals are made at the beginning of the year (starting January 1, 2017).
If the executive took the severance as income, he would pay $267,650, leaving him
If the net proceeds are invested and withdrawn evenly, the now-retired executive could expect to take $51,111.11 per year. He would pay no tax, as the majority of the cash flow would be return of capital.
At the end of the five years, a payout that cost the employer $509,750 will benefit the executive at 50 cents on the dollar. Had this severance instead been paid to an RCA, the retired executive would instead draw $104,961.48 from the RCA and refundable tax account (RTA) combined, and then pay tax on this amount as income.
In Ontario, this would equal $27,357 per year, for a net of $77,604.48. That’s 51.83% more than simply taking the severance directly and, at the end of five years, the executive would receive 76 cents on the dollar.
In this case, the results are in favour of the executive utilizing the RCA strategy. Even if the executive had other income over that period, the RCA ends up being the better option as long as the executive’s marginal tax rate is below 47.45%.
by Jason Pereira, MBA, CFA, CFP, FCSI, CIWM, PFP, FMA, partner and senior financial consultant at Woodgate Financial & IPC Securities Corp, and Brian Cabral, CFP, senior consultant at Gordon B.
Lang & Associates.